What Is Zero-Based Budgeting?
Zero-based budgeting is an accounting practice that forces managers to think about how every dollar is spent in every budgeting period. It can have both benefits and drawbacks.
Pete Pyhrr developed the idea of zero-based budgeting in the late 1960s to early 1970s while he was an account manager at Texas Instruments. Many Fortune 500 and private equity companies have adopted this budgeting technique since that time.
Key Takeaways
- Zero-based budgeting differs from traditional budgeting in that the companies using it create a budget for each new period.
- The benefits can include lower costs by keeping old and new expenses in check.
- Potential disadvantages are that it can reward short-term thinking and be resource-intensive.
- Zero-based budgeting can be manipulated by savvy managers.
Understanding Zero-Based Budgeting
A study from Accenture Strategy on zero-based thinking published in 2018 found that this budgeting method grew exponentially among the world's 85 largest companies at a rate of 57% each year from 2013 through 2017. These companies include Kraft Heinz Co., Mondelez International Inc., and Unilever PLC.
Companies start with the previous period's budget as a template in traditional budgeting. They then build upon it. Each new budget usually increases incrementally compared to the previous period's budget and companies only have to justify new expenses.
Zero-based budgeting deviates from traditional budgeting in that the budget for each new period is created starting from a "zero base." Companies must justify each expense before adding it to the new budget, even old and recurring expenses.
Benefits of Zero-Based Budgeting
The major advantages of zero-based budgeting are flexible budgets, focused operations, lower costs, and more disciplined execution.
Managers Must Justify All Operating Expenses
Zero-based budgeting ensures that managers think about how every dollar is spent and they must do so every budgeting period. This process also forces them to justify all operating expenses and to consider which areas of the company are generating revenue.
It Keeps Legacy Expenses in Check
Legacy costs may not be examined for years in traditional budgeting until there's some sort of economic shock that forces the company to take extreme actions. Expenses tend to grow over time with each department protecting its budget from cuts.
It can lead to significant misallocation of resources over time. Zero-based budgeting can prevent this from happening if it's done correctly.
Managers must justify all expenses with zero-based budgeting. It generally doesn't matter if the new budget is higher or lower than the one that preceded it.
Drawbacks of Zero-Based Budgeting
The disadvantages of zero-based budgeting include the possibilities of resource intensiveness, being manipulated by savvy managers, and bias toward short-term planning.
It Can Reward Short-Term Thinking
One of the major shortcomings of zero-based budgeting is that it can reward short-term thinking by shifting resources toward areas of companies that will generate revenue over the next calendar year or budgeting period. Some areas of companies that aretypically viewed as long-term investments that aren't directly tied to revenue may be left with smaller budgets than they actually need as a result.
These long-term investments can include research and development or worker training. This could potentially hurt a company because these areas are often the keys to remaining competitive over the long term but they won't be generating revenue in the near term.
It's Resource Intensive
Zero-based budgeting is also resource-intensive. It takes a lot more time and effort to closely review and justify every budget element rather than modify an existing budget and review only new elements. Some critics argue that the benefits of zero-based budgeting don't justify its time cost because of this.
It Can Be Manipulated by Savvy Managers
The process can be gamed by savvy managers to get more resources into their departments. This can lead to a change in culture. There's a decreased spirit of cooperation in the company because workers feel expendable.
What Are Operating Expenses?
Operating expenses are costs that a company incurs just to keep up and running. They don't include financing or investing. They produce revenue. They're either fixed, such as rent or mortgage payments, or they're variable, such as salaries paid to workers. Salaries can be tweaked if necessary. Mortgage payments are more carved in stone.
What Are Legacy Costs?
Legacy costs are expenditures that are associated with providing retirement and health benefits to a company's workers. They're a common expense for government employers but they're common among corporate employers as well.
Can a Zero-Based Budget Be Applied to Personal Finances?
It can and the math is really simple. Add your monthly expenses to the amount of money you'd like to save each month. Subtract the total from your monthly income. You have a zero-based budget if the result is zero or very close to it. You'll want to make adjustments if your budget is less than zero. You're in pretty good shape if it's more. Decide where you want to put that extra money.
The Bottom Line
Zero-based budgeting effectively creates a new, start-over budget for each accounting period. As the name suggests, each budget begins at zero. A focus like this can keep costs and expenses under a microscope and it can give managers more control. Opponents argue that this type of budgeting doesn't keep an adequate eye on future needs.
Business owners might want to do a trial run on paper first, at least for a little while, before jumping in with both feet and committing to the process.
